October 14, 2010
Center for Financial Policy Briefing Note
Pulling Back the Veil on Foreclosures
Today’s headlines showing that foreclosures have reached record levels punctuate the widening
debate over the causes and cures of the ongoing foreclosure crisis. It is tempting to assign full
blame for the crisis to widespread industry fraudulent behavior. The real answer, far more
complicated and deeply rooted in history, requires us to step back away from the politically
charged atmosphere of the approaching midterm elections and seek a clearer understanding of
what lies behind the foreclosure numbers. From that perspective, the foreclosure problem can be
attributed to four elements;
•
The economics of the transaction vis a vis workout alternatives; e.g., loan modifications;
•
The incentive structure of servicers, lenders and investors;
•
Operational and infrastructure deficiencies; and
•
The fragmentation of foreclosure laws and regulatory oversight in this country.
1 Servicers work on behalf of investors in ensuring that payments from borrowers are distributed
in a timely fashion, and when borrowers get into trouble, servicers attempt to triage loans in
accordance with a set of least cost criteria. In addition, many investors such as Freddie Mac
provide financial payments to servicers to align interests toward promoting pre-foreclosure
workout solutions. The simple fact then is that absent other causal factors at work, the
economics of loss mitigation activities should incent servicers to intervene early in the
delinquency process and develop economically viable workout solutions for the borrower and
investor. Unfortunately, other factors oftentimes prevent this from happening.
It should not be a surprise that foreclosures are mounting at what appears to be an alarming rate.
In part, the ineffectiveness of federal loan modification programs such as the Home Affordable
Modification Program (HAMP) in its various incarnations has so far been of limited help at
identifying permanent modification solutions for distressed borrowers. Recidivism rates remain
high and qualified borrowers fitting the eligibility criteria of the program along with NPV
models used to determine economically viable candidates pose the greatest challenge toward a
solution that truly stems the foreclosure tide. Underlying the loan modification issue is the
simple reality borrowing from financial theory that lenders wrote a put option to borrowers at the
time the loan was taken out and these options are now deep-in-the-money for borrowers due to
the crash in home values. Loan modifications, either by reducing interest rates, extending loan
terms and/or forgiving principal either readjust the strike price to prolong inevitable redefault or
2 cannot be structured sufficiently to avert future delinquency due to borrower credit and capacity
profiles.
Unfortunately, data suggest that about 50% of the time, servicers have been unable to contact
and reach out to distressed borrowers for various reasons. Although counseling efforts and
refinements to borrower contact strategies by servicing units has improved since the crisis began,
delays in establishing a dialogue early with borrowers on the path to foreclosure forestall
necessary actions to prevent foreclosure from becoming a reality. These delays, coupled with
programmatic design limitations of modification programs, contribute to an ominous buildup in
the foreclosure pipeline.
Building foreclosure inventories are compounded by vast operational deficiencies in staffing and
infrastructure across mortgage servicers. Rewinding to the boom years in housing, many
servicers emasculated their default and collections shops in light of short-term operational cost
efficiencies. The cyclical nature of mortgage servicers to optimize cost efficiencies was
empirically identified in a study I wrote some time ago and is reinforced today by apparent
widespread instances of mishandling of foreclosure cases in the industry.1 By the time the crisis
ensued, many servicers were caught flat-footed in what lay ahead in default management.
Staffing levels were down and the expertise limited – I know of one servicer for example, that
redeployed underwriting staff in 2008 to plug gaps in the workout units that were awash in
delinquent mortgages. Ill-trained to address the specialized needs of default management
1
Clifford Rossi, Mortgage Banking Cost Structure: Resolving an Enigma, Journal of Economics and Business, Vol
50, Issue 2, March-April 1998, pp. 219-234.
3 processes, these types of responses illustrate the staffing limitations at work. Another cost
containment strategy used by servicers was outsourcing certain aspects of default management
functions. Viewing the collections process as an assembly-line to achieve scale economies
vastly underestimates the extensive institutional knowledge required to develop effective
workout solutions fitting each borrower’s circumstances. The housing boom and bust also
witnessed significant consolidation within the servicing industry. An unintended consequence of
this consolidation was the difficulty in integrating servicing system platforms across acquired
firms. This led to significant systems limitations at a time when technology was critically
needed to handle the scale of defaulted mortgages now upon servicers. The phenomenon of
robo-signing and documentation lapses that appear daily in the media should therefore be of little
surprise.
Another significant contributing factor to the problem is a complete fragmentation of foreclosure
law and oversight of the process. At the national level there is no single authority responsible for
the ongoing assessment and oversight of mortgage servicing entities. For that matter, there is no
comprehensive federal overseer of national housing policy and unfortunately we can see all too
painfully the results from that gap. Bank regulatory agencies are charged with overseeing the
safety and soundness of depository institutions; however, the capacity and level of expertise of
examination teams is woefully inadequate to address the complexity and size of servicing
operations at other than a cursory level. Is it any wonder then that the vacuum left by the federal
government has been replaced by states attorneys general from across the country conducting
their own review of the foreclosure crisis?
4 Finally, state foreclosure laws in this country have created a byzantine maze of rules and
regulations that facilitate inefficiency, operational breakdowns and unevenness in the application
of fair treatment of borrowers across the country in foreclosure. It is well know that depending
on the state in which the foreclosure proceeding takes place and whether it is a judicial or
nonjudicial process, foreclosure timelines vary considerably.
Putting these elements of the foreclosure process together has given rise to a perfect storm of
foreclosures that is sure to be with us for some time. While the economics of servicing would
suggest that these entities opt for the least cost solution to default, implying a pre-foreclosure
workout would be in the best interest of all affected parties, short-sighted decisions made by
servicers to cut costs coupled with ineffective loan modification programs and a fractured
foreclosure legal and regulatory process has acutely accentuated an already dire problem.
Clifford V. Rossi, PhD, Executive-in-Residence and Tyser Teaching Fellow
Center for Financial Policy
Robert H. Smith School of Business
University of Maryland
Contact Information: crossi@rhsmith.umd.edu
The views of this article are those of the author solely and do not represent those of the
Center for Financial Policy or the University of Maryland.
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